How Do Personal Loans Work: What You Need to Know Before Applying

5 min read

Posted on March 29, 2022

personal banking sign displays how do personal loans work

Personal loans are one option for borrowers who need to secure funds for large purchases, projects, emergencies or to consolidate debt. They’re offered by private lenders, including banks, credit unions, online lenders and other financial institutions.

In this article, we’ll cover all things personal loans, including eligibility requirements, what they can be used for and the different types available to individuals.

What Is a Personal Loan?

A personal loan is money you can borrow from a financial institution, such as your bank, credit union, or favorite online lending marketplace. Unlike a secured loan, an unsecured personal loan doesn’t require collateral – like your home or car. Like any personal loan, if you are approved, you will make monthly payments to pay it back in full (plus interest) over a set duration of time. In general, the typical minimum personal loan amount is $1,000, and the maximum loan amount is $50,000, but will vary by lender.

In order to be approved for a personal loan, you’ll need to fill out an application so that the lender can determine your creditworthiness. Approval is based on various criteria and may vary among lenders, but generally includes your total income, credit history, the sum you’re requesting, and your stated goals for your financing.

There are many different types of personal loans, so be sure to explore your options before you start an application.

Obtaining a Personal Loan: Eligibility Requirements & How The Process Works

Your personal loan application process starts with meeting the eligibility requirements. If you don’t meet these, then your application may be rejected.

In order to be eligible for a personal loan, you typically need the following:

  • Fair to excellent credit score
  • No history of making late payments indicated on your credit report
  • A lower debt-to-income ratio is typically needed
  • Enough income to easily meet the new monthly payment based on the loan amount

These are guidelines to consider whether or not you may have a strong application, but the specific eligibility requirements vary between financial institutions. Most institutions perform a hard credit check to determine your creditworthiness. It’s a good idea to request your own credit report to help understand the strength of your application before you apply. You can find your credit score by applying for a free report every year from the three major credit bureaus: Experian, Equifax, and TransUnion. Learn more about credit reports and scores, including how to request your free credit report at

Different Loan Options

Before you receive any money, you’ll need to disclose why you’re requesting a loan. This is key to understanding how personal loans work. As you reflect on the type of financing you can receive, consider one of these loan options:

  • Debt consolidation loans: If you have more than one loan with high interest rates, like credit card debt from multiple accounts, you may want to consider a debt consolidation loan. These types of loans could provide you with a single monthly payment and may provide a competitive APR to avoid high-interest debt.
  • Home improvement loans: Home improvement expenses are such a common use for personal loans that many financial institutions offer specific terms for this type of loan. Apply for this type of loan to cover large repairs, major renovations, or small projects.
  • Unsecured personal loans: Most personal loans are unsecured. A potential benefit of choosing an unsecured personal loan is that you don’t have to put up any collateral. You still have to make consistent monthly payments. These loans may come with higher interest rates due to the increased risk they represent to the lender because there is no collateral.
  • Secured personal loans: You may want to consider this option for an interest rate that’s typically lower than unsecured alternatives. A secured loan may come with additional risks for you as the borrower because the lender can seize any collateral backing the loan. The most common examples of collateral include cars and homes. In fact, auto loans and home mortgages are examples of secured loans, where the borrower’s car and home, respectively, are the collateral.
  • Fixed-interest rate loans: A fixed-rate loan provides you with a set rate of interest throughout the life of the loan. This means that your rate will not change for the life of your loan. You’ll agree to make monthly installments of principal and interest to repay the loan over a predetermined length of time.
  • Variable-rate loans: While most loans use a fixed interest rate, variable-rate loans are available, but know that a variable rate could change during the life of the loan.

Personal loans can be used for a range of large purchases. The average personal loan balance in 2020 was $16,458, according to Experian. Whether you have home repairs, medical bills, or other upcoming expenses, it’s important to consider these types of personal loans and your situation to help identify competitive rates and the most convenient loan terms.

What Can You Use a Personal Loan For?

Personal loans can be a viable solution for many different use cases. You can take out a personal loan for a wide range of financial reasons. The most common reason for taking out a personal loan in 2020 during the pandemic, according to Forbes, was for home improvement. Approximately 25% of personal loans were used for this purpose.

Carefully review the rules and restrictions for personal loans outlined by various financial institutions. While this type of financing is particularly flexible, your loan agreement will outline restrictions on personal loan use.

Here are some of the most common uses for personal loans:

  • Debt consolidation
  • Medical bills
  • Home improvement expenses
  • Vehicle purchase
  • Wedding expenses

There are also commonly restricted uses. A debt consolidation personal loan may be used to cover credit card or medical bills but can’t be used for student loans. In most cases, you can’t take out a personal loan to cover a down payment on a home, pay off student loans, or cover business expenses. Review your options with a credit union or other financial institution to learn about other financing options for these situations.

Personal loan applications require you to state the purpose for the loan – literally how the funds will be used. You can receive personal loans for many different reasons, but you’ll need to state in writing what you intend to use this financing for before you become approved. You can’t apply for a home improvement loan and then decide to spend it on a vehicle purchase, for example.

Ask about restrictions and requirements for other types of lending if you wish to use your financing for an expense not covered by personal loans.

Frequently Asked Questions

Are there any restrictions on what I can use a personal loan for?

Talk to your specific lender to determine the exact restrictions on your personal loan. The most common restrictions prevent you from using personal loans to cover business expenses, home down payments, and student loans. Other restrictions may apply, and virtually every personal loan application requires you to state the specific reason you’re applying.

Are there any fees associated with a personal loan?

Personal loans may include origination fees and prepayment penalties. Origination fees can be anywhere from 1-10% of the loan amount, according to reporting from CNBC. Prepayment penalties occur if you pay off the loan before the end of its term, or before a predetermined amount of time. Both of these fees vary depending on the lender. Consider the cost of fees as you compare personal loans from different lenders.

Can I refinance a personal loan?

Refinancing personal loans is usually possible. A lender can refuse to refi their own personal loans, but they cannot stop you from refinancing your personal loan with another lender. Refinancing involves applying for a new loan typically from a new lender to receive new repayment terms and a new interest rate. Review your credit agreement (also known as your loan note) to make sure you understand your contractual obligations or reach out to a personal loan professional.

How can I figure out my total interest costs?

A personal loan calculator could help you estimate the monthly payment and total cost of interest once you input the loan amount, estimated interest rate, and repayment term. This may allow you to clearly compare terms between various lenders.

Check Today’s Personal Loan Rates

Personal loan rates often change and vary between credit unions, banks, and online lenders. If you’re planning a big project or are concerned about existing debt, then a personal loan could be worth considering.

Check today’s rates through Splash and explore whether a personal loan may be right for you.


The information provided in this blog post is not intended to provide legal, financial or tax advice. We recommend consulting with a financial adviser before making a major financial decision.

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